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Yum! Brands, Inc. (YUM), McDonald’s Corporation (MCD): Is The Cost of Doing Business Too High?

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Yum! Brands, Inc. (NYSE:YUM) has just suffered another setback in China as the focus of a Chinese Central TV investigation claiming the ice at KFC in China is worse than toilet water, with nineteen times the bacteria allowed in Chinese drinking water.
Yum! Brands, Inc. (NYSE:YUM)

Reporters for CCTV tested the ice at KFC, McDonald’s Corporation (NYSE:MCD), and fast food chain Kongfu. All three failed government standards for potability, but McDonald’s Corporation (NYSE:MCD) ice was cleaner than toilet water. Yum! Brands, Inc. (NYSE:YUM) and McDonald’s Corporation (NYSE:MCD) issued statements they would be investigating, and that food safety was their highest concern.

Yum! Brands, Inc. (NYSE:YUM), with 39,000 KFC, Taco Bell, and Pizza Hut restaurants, was beginning to recover from its December 2012 chicken controversy, in which its supplier Liuhe Group was providing chickens with excessive antibiotics and growth hormones. June same store sales at KFC China had improved, although they were still down 10%.

Yum! Brands, Inc. (NYSE:YUM) was the China play for investors wary of investing in Chinese-based companies, and with China accounting for over half of Yum! Brands, Inc. (NYSE:YUM)’s revenue things were just Peking ducky.

Yum! Brands, Inc. (NYSE:YUM) has now reported three consecutive disappointing quarters, and a highlight of the most recent Q2 report on July 10 was a 20% drop in same store sales in China, a 63% decline in Chinese operating profit, and a 5.0 percentage point decline in margins, again, thanks to China.

CEO David Novak two weeks ago said, “The good news is that China sales are recovering as expected. The extensive media surrounding Avian flu in China has subsided and same-store sales at KFC are clearly improving… As KFC sales continue to recover, we expect to have solid momentum in China heading into 2014.”

He also announced the company was on track to open 700 new China KFC restaurants this year, for a total of 1,600 opened over these last two years.

At least India sales offset miserable China numbers with a 24% increase. US sales were only up 1% and Yum! Resorts International division sales were up 6%, mainly driven by a 12% gain in emerging markets.

Whatever good news the company reports about successes like its Taco Bell Cantina Grill menu gaining traction against Chipotle Mexican Grill, Inc. (NYSE:CMG), or its new boneless chicken, is always overshadowed by one country out of 125…China.

Chinese consumers’ reluctance to eat at KFC is understandable, what with China’s dismal history in food safety–but one has to wonder if there is a concerted effort to discredit Yum! in China as the company was vindicated in May after false accusations over tainted lamb at its Little Sheep franchises.

KFC has been in China for 26 years, and these two safety scares, both publicized on Chinese television, have hurt a quarter century’s worth of goodwill earned by KFC and the image of venerated elder Col. Harlan Sanders. James McGregor, author of One Billion Customers: Lessons From the Front Lines of Doing Business in China,told Bloomberg in 2011,”If Yum’s China business went south, it would kill the stock.”

Obviously Yum! won’t exit China; a market of a billion chicken-lovers is too good to pass up. The expected recovery of Chinese sales will likely be pushed back several more quarters, assuming another shoe doesn’t drop. Yum! has a PEG of 2.09 and a trailing P/E of 22.09 with a 1.90% yield. It’s a shareholder-friendly company and has bought back 5.7 million shares this year.

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